New GAAP Accounting Rules for Income Taxes

George September 21, 2007 — 2,230 views

Enterprises that issue financial statements based on generally accepted accounting principals (GAAP), must implement new accounting rules for uncertain tax positions, especially those taxed as a C corporation. Pass-through and not-for-profit enterprises also are subject to the new rules and could be affected in some circumstances.

Financial Accounting Standards Board (FASB) interpretation number 48 (FIN 48), Accounting for Uncertainty in Income Taxes, is effective for financial statement periods beginning after December 15, 2006. Enterprises registered with the Securities and Exchange Commission (SEC) were required to implement these rules in 2007 first-quarter filings.

FIN 48 imposes new standards for recognizing, classifying and disclosing tax positions, penalties and interest in GAAP financial statements. The term tax position refers to a position taken in a previously filed tax return––or one expected to be taken in a future tax return––that is reflected in measuring current or deferred income tax assets and liabilities for interim or annual periods.

FIN 48 applies only to income-based taxes, so it does not apply to sales and use taxes, taxes based on assets or capital, i.e., many state franchise taxes, and real and personal property taxes.

A tax position can result in a permanent reduction of income taxes payable, a deferral of income taxes otherwise currently payable to future years or a change in the expected realizability of deferred tax assets. It also can encompass but is not limited to:

A decision not to file a tax return

An allocation or shift of income between jurisdictions

The characterization of income or a decision to exclude reporting taxable income in a tax return

A decision to classify a transaction, entity or other tax return position as tax exempt

Simply identifying potential uncertain tax positions will be a challenge for many enterprises and their auditors. Whether performed by an internal tax department or outside accountants, previous tax returns, workpapers, tax strategies, contracts, etc. should be scrutinized for material uncertain tax positions. Non-filing of state returns, aggressive or non-existing transfer pricing and other international issues and improper methods of accounting are typical uncertain tax positions.

Another challenge involves enterprises with foreign locations or operations that are reflected on the financial statements. U.S. accountants lack expertise in the tax laws of foreign jurisdictions and foreign accountants may not understand the requirements of FIN 48. Nonetheless, FIN 48 must be applied to foreign income taxes, so foreign accountants may have to be educated on the requirements of FIN 48.

Once potential uncertain tax positions are identified, they must be evaluated for financial statement recognition. The evaluation of a tax position is a two-step process. First, an enterprise must determine whether each tax position, based on its technical merits, is more likely than not to be sustained on examination. Enterprises must presume an appropriate taxing authority––one with full knowledge of all relevant information––will examine each position. Tax benefits may not be recognized if they are generated by positions that do not meet the “more-likely-than-not” standard.

Second, measure tax positions that meet the more-likely-than-not threshold to determine the amount of benefit that may be recognized in the financial statements. Enterprises also must accrue additional expense where a tax position would result in penalties and/or interest. Summary disclosure of uncertain tax positions in financial statement footnotes also is required.

Clearly, FIN 48 will primarily affect taxable entities. However, tax-exempt not-for-profit entities will need to determine their compliance with FIN 48 concerning overall exempt status, unrelated business income tax (UBIT), taxable affiliates and other issues. S corporations also may be affected by FIN 48 with regard to corporate-level taxes.

FIN 48 implementation will pose some challenges to accountants. First, FIN 48 will require additional audit procedures for accountants who are already stressed for time because of other new auditing and regulatory requirements, e.g., SOX, and an industry-wide staffing crunch.

Second, many enterprises, especially those with no internal tax department, will no doubt ask their auditors to help them implement FIN 48. This raises independence concerns. Clearly, the performance of FIN 48 assistance to an SEC client would impair independence, but what about non-SEC clients? The AICPA has issued a non-authoritative FAQ providing that the provision of FIN 48 assistance will not impair independence provided the client can make an informed judgment on the results of the member’s services and the other requirements of Interpretation 101-3 are met. For additional details about this FAQ, as well as other materials concerning FIN 48, visit the AICPA’s website at www.aicpa.org.

Third, accountants may have allowed or advised tax positions that did not meet the more-likely-than-not standard, but met the realistic possibility standard (generally at least one-in-three chance of success based on the merits) of Circular 230 and AICPA professional standards. Some clients may no longer wish to take such positions, so associated tax strategies may have to be undone or tax returns may have to be “cleaned up”.

Finally, many commentators have expressed concern that the disclosure and documentation requirements of FIN 48 will create a “roadmap” for IRS examiners. The service has issued official guidance, which for now, curbs much of this concern.

The IRS has formally instructed its personnel that FIN 48 documents produced by taxpayers and their auditors are to be treated as tax accrual workpapers (TAW). TAW are “audit workpapers, whether prepared by the taxpayer, the taxpayer's accountant or the independent auditor, that relate to the tax reserve for current, deferred and potential or contingent tax liabilities, however classified or reported on audited financial statements and to footnotes disclosing those tax reserves on audited financial statements.”

While the IRS has the legal authority to obtain and examine TAW, it has a self-imposed formal policy of restraint, requesting TAW only in unusual circumstances, e.g., where a listed transaction is discovered. Thus, while IRS agents carefully review and analyze the financial statement footnotes as part of the examination planning process, they generally will not request FIN 48 documentation. However, in the same guidance, the IRS says it is evaluating its TAW policy to ensure it is still appropriate in today's environment.

Further, the IRS’s long-standing policy of not re-opening tax years that have been examined and closed, barring “exceptional circumstances,” will continue. However, the IRS says it is possible re-openings may occur more frequently.

The IRS guidance to its agents is good news for taxpayers subject to FIN 48, though a cautious optimism is prudent, because IRS agents may be increasingly tempted to seek “unusual circumstances” to ask for TAW. It is also possible the IRS may change its policy of restraint for requesting TAW.

FIN 48 will definitely be a big deal for many enterprises, as well as accountants. Affected parties should plan now to identify and assess potentially uncertain tax positions to avoid surprises during the next financial statement audit or review or busy season.

George S. “Chip” Storey is senior manager and associate director of tax services with BKD, LLP, one of the 10 largest CPA and advisory firms in the United States. He assists the director of tax services with the management and quality control of the firm’s tax practice, including internal peer reviews and tax communications. He also assists with technical tax matters and the development of firmwide tax resources. Contact the author at [email protected].

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